Published Articles on Money Questions (continued)

Articles written by LYFORDS directors Alison and Richard Renfrew, and published in the Wellington Newspapers Ltd, Evening Post Newspaper.
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Additional articles published please also refer to this link:
[
Your Money Column]

Education Savings:
Education Savings 
 

Shares:
Buying Shares 
 

Mortgages Interest:
Mortgage Interest Rates 
 

Investments:
Passive Funds and Unit Trusts 
Diversification 
 
 

Family Trusts:
Family Trusts 
 

Scams:
Returns of 20 percent per month .. wow !!! 
 

Managed Futures:
How do Managed Future funds reduce the risk?

Education Savings 

We are saving for our 10 year old son's tertiary education. We currently contribute $65 per month and have a total savings account of $5,000. The account is an advantage saver which currently pays 3.5% interest plus 0.5% pa bonus for each month of no withdrawals. Should we continue with this method of savings, invest the lump sum, move to unit trusts (are there ones with no entry fees?).

Answer:  With another 8 years of savings to go you should definitely be looking at investments with potentially higher returns. Our recommendation is unit trusts because of the ease of diversification that these offer. Your investments should have exposure to international equities which will potentially give you higher returns, but are also higher risk. These are available with no entry fees from discount brokers or through the internet. Don't be put off paying entry fees if you are getting good service and advice. The role of an investment adviser is to discuss your options. When you invest directly do not expect personalised service or advice.

Incidentally university surveys show in present day dollars your son may need to provide $13,900 if he lives away from home or $6,600 per year if he lives at home. You will need to inflation adjust your savings. Based on 5% real rate of return (net of inflation, management fees and tax) you should increase your contributions by $16 per month if you want to meet a $6,600 per year target for 3 years.
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Buying Shares 

Question: If I want to buy shares, where should I go to get the best deal?

Answer:  If you know exactly the shares you want then we recommend going to a discount broker (no advice brokers) or the Internet. There are a lot of options and we suggest you pay a higher entry fee and get sound advise from a share broker. Don't put all your money in the NZ share market. If the amount you are considering investing is greater than 10% of your income we recommend diversified funds (unit trusts) with exposure to international equities.
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Question: I have $50,000 on a one year term deposit that matures in May. The interest rate is 8.8%, but I won't get that again as interest rates have halved. I don't intend to use the money for a few years so is it best to invest it back in the bank, or should I look elsewhere?

The answer to this depends on your age and your attitude to investment risk. With money in the bank there is little risk of capital loss, but the returns are low. If your investment time horizon is 2 to 3 years then a diversified portfolio exposed to all asset classes both within NZ and offshore would potentially provide higher returns than a fixed interest deposit. For investment time horizons below 12 months, stay with fixed interest deposits because of uncertainty in investment returns and entry fees. Since you do not need your money for the next few years we recommend you invest in a diversified portfolio. We recommend discussing investment options with your bank or an investment adviser.
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Mortgage Interest Rates 

Question: I read with interest your advice to fix your mortgage at 3 or 5 years at less than 6% I checked the rates published in Saturdays Evening Post and was unable to find such a low rate. Also I would like to know the advantage of fixing and floating part of a mortgage.

Answer:  Indeed you are right, at the time of writing the response to this question there were such interest rates. The lowest at the moment is 6.5% for 2 years. There are floating rates around of 4.95% with special conditions. We recommend discussing your options with a mortgage broker. There are several reasons to go to a fixed rate mortgage. This helps with budgeting as you will know your mortgage payments for the next 2-3 years and you are probably speculating that interest rates will increase. Often on a fixed mortgage rate you will not be able to make lump sum payments of capital. With a floating mortgage you are speculating interest rates will decrease or you want the flexibility to make lump sum payments of capital. That's why a combination of the two can be the best option. If you have an income over $50,000 and are paid monthly then a revolving credit facility, when handled prudently, can reduce the overall interest payments and term of your mortgage.
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Passive Funds and Unit Trusts 

Question: About two years ago my adviser put me into Passive Funds. Are Passive Funds still appropriate. I have lost money should, I change my investments?

Answer:

  Two years ago Passive, or Index tracking funds, were the 'new boys' on the block in New Zealand and these were all the rage. One Research House was recommending for your New Zealand investments 60% of your equity asset class should be in Index Funds. We believe Passive Index tracking funds are inappropriate for the New Zealand market. The AMP WINZ, which is an international equity passive fund, has performed well.

Passive, or Index funds are where the fund manager may put together a portfolio based on the top 10, 15, 30 or 40 shares in the New Zealand share market. The index usually reflects the percentage spread by capital value. At the time the IRD provided a ruling that these funds would not be taxed on any capital gain. The dividends were still taxed at 33% with imputation credits.

While a lot of fund managers were quick to get in after the Share Exchange launched their top 10 fund other fund manager's, notably Armstrong Jones and Bankers Trust, declared that they were 'active' fund managers and could add value by actively managing portfolios. This month AXA NZ Ltd (National Mutual) are withdrawing their Kiwi Share Index Fund and it is likely others will follow.

A passive (index fund) managed investment is unable to protect an investor from the market. This means that passive investor's returns reflect all the highs and lows of the market's performance.

New Zealand is a particularly volatile, high risk market and in our opinion you should take the loss and move your funds into actively managed equity funds making sure you have exposure to off-shore markets.
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Question:

  I cashed in a unit trust investment recently and the bank asked 'do you want to withdraw by the 'Direct Redemption Method' or by the 'Manager Repurchase' Method. although the bank adviser tried to explain the difference to me I really didn't understand the explanation. Can you explain this to me simply?

Answer: 

Firstly Unit Trust's or Managed Funds are where you pool your money with other investors money and the 'fund manager' invests this money by buying shares, or bonds etc. either in NZ and, or offshore.

Since a fund manager is actively trading shares they pay capital gains tax at 33% on any profits they make. All dividends paid out are also taxed at 33% and you get credit for the tax that the fund manager has paid on the dividends by the way of an 'imputation credit'.

On April 1, 1996 a taxation law came into effect for unit trust investors. Effectively you have to elect how you want your investment proceeds paid out when you withdraw. The options are "Manager Repurchase" or "Direct Redemption".

When you sell your units via "Direct Redemption" any gain over your initial subscribed investment is taxable as a dividend and must be declared as assessable income. You do receive 'imputation credits' on the dividend declared. If you are on a tax rate below 33% then you can use the imputation credits, which have been taxed at 33% to offset your overall tax liability.

When you sell your units by "Manager Repurchase" any gain you make over your initial investment is not declared in your personal return of income at year end, as long as you are not deemed by the IRD to be a trader.

In plain English, when you withdraw your funds you are paid out the same amount regardless of the option you choose. If your tax rate is below 33% then we recommend "Direct Redemption". Be careful though, because you will be effectively declaring that you have received a dividend. You will have to declare this as extra income. This may affect certain situations where you want your income to remain low. For example if you are a liable parent and eligibility for community services card.
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Family Trusts 

Question:

  My friends say I should set-up a family trust, what do you recommend. I have a home worth $240,000, investments of $300,000, income from my late husband's superannuation of $12,000 pa. I am age 63 and have two children in their 20's. Would you please explain how a family trust works and if I should have one. I don't want my assets to be used up paying for rest home costs, I have paid my taxes.

Answer:

The reason for setting up a discretionary family trust is to protect your assets from business risks, social welfare, children or their spouses and to make the passing on of one's estate easier.

The earlier you set up a family trust the better and your situation should be discussed in more detail with a solicitor, financial planner or accountant. Question your adviser about their experience with family trusts. Family trusts is too complex a topic to cover in this short article. As with going to any adviser it is a good idea to have some background of the topic so that you can ask more specific questions. One book on the subject of Family Trusts we particularly like is the book by Ross Holmes, "Trusts - Using a Trust to Protect Your Assets". Ross gives very useful examples in the Appendix of the documentation you use in running a trust.

Once you have a trust you need to transfer your assets into the trust. Investments can be transferred into a trust at no cost. You simply write to the investment manager saying please change the ownership to your family trust and all trustees then sign a new application. With direct shares you get a form from the Share Registry. With property this needs to be done through a solicitor and they will register the ownership change with the land transfer office. The cost will be around $500-600 or more if there is a mortgage on the house.

At this stage your assets are not protected. The Trust owns the assets but legally also owes you a debt of the value of the assets. You need to go through a gifting programme. The Government allows you to make a gift of $27,000 per year without paying gift duty. You do need to send the IRD a gift statement each year and you need to write a 'Deed of Partial Forgiveness of Debt' each year. The gifting should be done 365 days after the last gifting.

Social Welfare have a policy of looking back 5 years into your finances but they can look back many more years than this, if they choose. You should always document more than one reason for setting up a family trust.

If you went into a rest home and you have all your finances in a discretionary family trust and Social Welfare come along and say, we want that money, the trustees are there to protect all the beneficiaries and they can say, it is not in the best interests of the beneficiaries to pay the rest home fees.

Coming back to your situation, on the facts given you do not have an outstanding case for setting up a trust. To set-up a trust will cost around $1,200. If you have a house then you will be looking at a total cost of around $2,000. You have around $540,000 of assets. Gifting at $27,000 per year would take 20 years. Your gifting process may not be complete if you go into a rest home.

A discretionary family trust can be wound up on your death and the assets distributed or it can continue for 80 years from the start date. We recommend that you are one of the trustees and have the power of appointment (POA) of trustees. On your death this POA can be willed to one of your children.

Rest home costs are likely to be around $28,000, higher if you need 24 hour care. In your case fear of using your assets up in rest home costs is not a sufficiently strong reason for setting up a family trust. You have $12,000 tax paid from your late husband's superannuation. At age 65 you will be eligible for New Zealand Superannuation, $212.69 net per week or $11,050 pa. Your investments, properly invested should generate around $12-20,000. This is in excess of likely rest home charges. The Government is likely to bring in some form of superannuation claw-back in future, which would reduce your overall income. The uncertainty of future Government changes may be sufficient reason for taking action now.
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Diversification 

Question; I have heard that investing a proportion of a portfolio into managed futures funds can lower the risk and increase the return of the portfolio. Do Mr & Mrs Renfrew agree with this? If they do, what funds would they recommend and where can I get information on them?

Answer:  We totally agree that the use of futures will lower the risk and increase the return of an investment portfolio. For those readers who may not know what managed futures are; futures managers generate a return by entering into agreements (futures contracts) obligating them either to deliver or receive an asset at a future date for a pre-determined price.

Individual futures contracts can be purchased on the futures exchange, refer to a share broker. Unless you are a sophisticated investor and like taking risk then we do not recommend holding direct futures contracts. The simplest way is through a "managed futures fund" operated by a fund manager. With these the fund manager has the expertise and can access a broad array of investment strategies. There are up to 40 distinct futures markets ranging from currencies to commodities, to share market indices to Treasury securities. The trading styles are classified as either 'systematic' or 'discretionary', or a combination of the two. Systematic managers trade by following non-emotional sets of trading rules. Discretionary managers apply their judgment and intuition in making every trading decision.

The risk, or volatility of a portfolio of investments is basically the variation of returns that occur. A higher risk portfolio, or investment will have a greater spread or variation of return. The most fundamental principle of any investment portfolio is "diversification". That is, spread your risk by using a combination of asset classes. The main asset classes are cash, fixed interest, property, equities (shares) and futures.

So how do managed futures reduce the risk of a portfolio and increase returns?

Managed futures have a low correlation with all other asset classes. If two investments increase, or decrease, by the same amount when market conditions change, these investments are deemed to have a correlation of 1.0. If the change is completely opposite to each other the correlation coefficient is negative 1.0. If the changes are random then the correlation coefficient is 0. Managed futures tend to have a correlation coefficient of zero against all other asset classes.

So what does this mean?

The result is that when you combine asset classes, which have no relationship (correlation) with other asset classes, the overall risk (or variation in returns) of your investment portfolio drops. Managed futures funds tend to have higher returns and higher risk than other asset classes but when combined with a diversified portfolio they increase the return and decrease the risk of the portfolio.

When seeking advice on using managed futures funds with your investment portfolio we recommend you visit a financial planner. Many financial planners do not recommend futures (maybe out of ignorance) and of the two main Research Houses in NZ only one recommends futures. Why? In 1987 the US share market dropped 25%, the average managed commodity futures fund returned 60.97%. Another fund returned 52.8% when the NZ share market dropped 51.7%. Using managed futures is like an insurance policy in your portfolio, when share markets are most volatile these funds give their best returns.

If you are a highly aggressive investor, that is, you only have equities and shares in your portfolio then we recommend a 80:20 split of equities: managed futures. Depending on your risk/return investment profile for a diversified portfolio we recommend anywhere from 5-10% futures. It would be best to discuss your specific situation and risk preference with your financial adviser.
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Question:

Is the Reserve Bank's new "cash rate" going to affect me?

Answer:

  The Reserve Bank's move from dropping the controversial monetary conditions index (MCI) approach to announcing every 6 weeks an official cash rate (OCR) was a very significant change. The Reserve Bank announced an OCR of 4.5% which was 0.5% above market expectations suggesting that the Reserve Bank doesn't subscribe to the theory that inflation is dead. The higher cash rate than expected was to dampen out the effects of inflation and provide a stable interest rate environment. The Reserve Bank does not expect a significant rise in interest rates until well into 2001, excluding any significant impact from any off shore events.

So what does this mean for you?

NZ has finally joined the rest of the world in terms of interest rate curves. Businesses will be able to forward plan better. The public will continue to enjoy low interest rate mortgages. You don't have to run out and get a fixed rate mortgage. There will be less volatility, or movement in interest rates compared with the MCI approach, which tried linking movements in the exchange rate with interest rates and inflation.
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Question:

  I was fortunate to buy Telecom shares when the company floated in 1991. My shares have been a fantastic investment but I'm now beginning to wonder if its time to sell. What do you think?

Answer:

This comes back to the most fundamental investment principle, diversify don't have all your eggs in one basket. While Telecom has had a fantastic return and has a predominate effect on the NZ share market index it is our opinion that returns have leveled out. There is more competition for the services Telecom provides. We suggest you take some of your winnings and spread your risk.
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Rental Property and Tax 

Question: Should my rental properties be placed in a trust?

I own 3 residential properties which I intend to continue to own when I am retired. What is the correct ownership for owning properties? Should I put these properties into a trust, or a company, or keep them in my own name?

Answer:  Firstly, we encourage you to sell your rental properties once you have retired. You will enjoy a higher income and your investments will grow better, so that your income will keep pace with inflation, when you invest in shares, especially international ones. Property investments work well when you have put none of your own money into the property and when the tenants are paying your mortgages. They are not an effective investment once they are fully owned by you. The more of your own capital you 'invest' into a property, the lower your investment return will be.

In the meantime your question is: what is the correct form of ownership? The main reason people establish discretionary family trusts is to ensure that their wealth will be distributed in the method they choose it to be. Trusts were evolved about 800 years ago with the purpose of protecting the assets of a family. It follows that a primary duty of every provider is to protect and provide adequately for his or her family. An important step to ensuring that your family is protected is to establish a family trust.

The downside to placing investment properties, that are well leveraged, into a trust is that you cannot claim the tax losses unless your trust has other income. If you form a loss adjusting qualifying company you can offset the tax losses against your own personal income. We question why you would bother and suggest that you keep the properties in your own name. It is hard to justify the establishment and compliance costs just for 3 rental properties. If you think there is a possibility that creditors or predators may attack your wealth base transfer your property to a trust, where it cannot be attacked, unless the bank has a claim on your mortgage. You would miss out on the tax losses which makes the investment very unattractive. Generally we advise people to simply keep their investments in their own names. There is always a risk in business. If you play it safe why bother?
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Returns of 20 percent per month .. wow !!!   

Question: I have heard of investments trading in secret private banking securities where returns of 20% per month are being suggested. If these returns are real I don't want to be missing out, but I also do not want to loose money if this is some sort of scam?

Answer:

  The storyline usually begins with "there is an entire banking and trading system which is not open to the general public". The material given and arguments sound very convincing. "A big lie is more plausible than the truth", Ernest Hemingway.

In May 1998 the International Chamber of Commerce warned investors about a new kind of investment scam being pitched over the Internet. They estimated investors had lost more than $30 million by investing in "bank debenture trading programs". The Bank of England on its web site warns: "Beware of unbelievably good deals. As a general rule they are unbelievable".

There is a lot of information on the Internet, some of it good, and some of it rubbish. The general belief is that if you see something in print it seems a lot more authoritative than if you get a phone call.

The way some of these schemes may work is that you are initially skeptical, but the thought of 20% per month returns when the banks are offering 4.5% for a year, gets you excited. You place $1,000 with the promoter. A week later, the promoter gives you back $1,500. You are amazed and still slightly skeptical so you give them $20,000. The promoter gives you back $30,000. Wow! You then give them your life savings. You hear nothing. You finally make contact, "Oops" they say, "that last trade didn't work and you lost all your money. Oh and by the way what you were doing under the securities act was illegal so don't tell anyone or you will go to jail". Or some other variation of this.

There have been other offers over the phone from share broking companies based in Hong Kong, the Philippines, and Indonesia. We have been approached by these companies. They usually offer insider information and say a share is going to take off. A similar process as described above will occur, initially some wins, then they get you to invest more and you will probably not hear from them again.

Then there are those persistent Nigerians. Last year we received 3 letters. The NZ Post Office intercepted 200,000 letters over a 12 month period. Apparently this is the 3rd largest industry in Nigeria. The scam usually goes, they have $40 million dollars they want to get out of the country and they will give you $12 million commission. All they need is your bank account number. Later they make a request for money to bribe officials. The letters always sound very credible and they even include references and phone numbers of people who have made money from the scheme.

Some of these schemes will offer offshore conferences for various reasons where you will be given educational material and an offshore trust may be set-up for you. Essentially these schemes may be multi-level marketing schemes where you can sell the same stuff to your friends.

When investing, a golden rule is, "the higher the return the higher the risk". We recommend you seek professional advice. Make sure you check out their qualifications. Invest in a diversified portfolio and spread the risk so that you can sleep at nights. The returns won't be an earth shattering 20% per month, but over time they will outperform bank fixed interest rates.

If you are offered something which has high returns, or you are suspicious of the people offering them, then phone the Serious Fraud Office, 09-303-0121.

A starting point for further information on the following schemes we recommend referring to these Internet sites: http://www.consumer-ministry.govt.nz/scam alert.html
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How do Managed Future funds reduce the risk?  

Question: I have heard that investing a proportion of a portfolio into managed futures funds can lower the risk and increase the return of the portfolio. Do Dr & Mrs Renfrew agree with this? If they do, what funds would they recommend and where can I get information on them?

Answer:

We totally agree that the use of futures will lower the risk and increase the return of an investment portfolio. For those readers who may not know what managed futures are; futures managers generate a return by entering into agreements (futures contracts) obligating them either to deliver or receive an asset at a future date for a pre-determined price. While there is an obligation to either deliver or receive the underlying asset, the pork bellies or barrels of oil (or whatever the asset happens to be) it never actually changes hands.

Individual futures contracts can be purchased on the futures exchange, refer to a share broker. Unless you are a sophisticated investor and like taking risk then we do not recommend holding direct futures contracts. The simplest way is through a "managed futures fund" operated by a fund manager. With these the fund manager has the expertise and can access a broad array of investment strategies. There are up to 40 distinct futures markets ranging from currencies to commodities, to share market indices to Treasury securities. Managed futures managers trading styles are classified as either 'systematic' or 'discretionary' or a combination of the two. Systematic managers trade by following non-emotional set of trading rules, discretionary managers apply their judgment and intuition in making every trading decision.

The risk, or volatility of a portfolio of investments is basically the variation of returns that occur. A higher risk portfolio, or investment will have a greater spread or variation of return. The most fundamental principle of any investment portfolio is "diversification". That is spread your risk by using a combination of asset classes. The main asset classes are cash, fixed interest, property, equities (shares) and futures.

So how do managed futures reduce the risk of a portfolio and increase returns?

Managed futures have a low correlation with all other asset classes. What is meant by correlation? If two investments increase, or decrease by the same amount when market conditions change these investments are deemed to have a correlation of 1.0. If the change is completely opposite to each other the correlation coefficient is negative 1.0. If the changes are random then the correlation coefficient is 0. Managed futures tend to have a correlation coefficient of zero against all other asset classes.

So what does this mean?

The result is when you combine asset classes which have no relationship (correlation) with other asset classes the overall risk (or variation in returns) of your investment portfolio drops. Managed futures funds tend to have higher returns and higher risk than other asset classes but when combined with a diversified portfolio they increase the return and decrease the risk of the portfolio.

When seeking advice on using managed futures funds with your investment portfolio we recommend you go to a financial planner. Many financial planners do not recommend futures (maybe out of ignorance) and of the two main Research Houses in NZ only one recommends futures. Why? In 1987 the US share market dropped 25%, the average managed commodity futures fund returned 60.97%. Another fund returned 52.8% when the NZ share market dropped 51.7%. Using managed futures is like an insurance policy in your portfolio, when share markets are most volatile these funds give their best returns.

If you are a highly aggressive investor, that is you only have equities and shares in your portfolio then we recommend a 80:20 split of equities: managed futures. Depending on your risk/return investment profile for a diversified portfolio we recommend anywhere from 5-10% futures. It would be best to discuss your specific situation and risk preference with your financial adviser.

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